The Madras High Court has upheld the revision of a reassessment order that left ₹61.97 lakh in accumulated interest untaxed when zero-coupon debentures were converted into equity shares.
The bench of Chief Justice Sushrut Arvind Dharmadhikari and Justice G. Arul Murugan has observed that receiving shares of monetary value against interest can amount to receipt of income, even for a taxpayer following the cash system of accounting.
The taxpayer, a director and shareholder of AVR Swarna Mahal Jewellery Pvt. Ltd., received 5,006 zero-coupon convertible debentures in September 2009. Each had a face value of ₹2,000 and a higher redemption value payable at maturity.
The company converted the debentures into equity shares ahead of maturity in 2012. According to the judgment, the shares allotted to the taxpayer had a total value of ₹1,75,58,082. This comprised the debentures’ initial face value of ₹1,00,12,000 and accumulated interest of ₹75,46,082.
In the return for AY 2013–14, the taxpayer reported ₹13,48,913 as interest income and claimed credit for tax deducted at source. The remaining ₹61,97,169 in accumulated interest, relating to earlier financial years, was not offered to tax.
The Assessing Officer reopened the assessment to examine that amount. The taxpayer argued that she followed the cash system of accounting and had received shares, rather than cash. She also relied on Section 47(x) of the Income-tax Act, 1961, which excludes conversion of debentures into shares from being treated as a transfer for capital gains purposes. The Assessing Officer accepted the explanations and passed a reassessment order without an addition.
The Principal Commissioner of Income Tax invoked Section 263 of the Act, finding that the Assessing Officer had failed to properly examine the interest included in the value of the shares. The Commissioner set aside the reassessment order and sent the matter back for a fresh determination. The Income Tax Appellate Tribunal upheld that revision, prompting the taxpayer’s appeal to the High Court.
The High Court said that an assessment can be revised under Section 263 when it is both erroneous and prejudicial to the interests of the Revenue. Accepting a claim without the necessary inquiry or proper consideration of the applicable law can satisfy that test.
Here, the company had discharged its obligation for accumulated interest by allotting shares that included the interest value, the court found. Receipt of income need not take the form of physical cash: allotment of valuable shares in settlement of an amount due can constitute constructive receipt. The taxpayer’s cash basis of accounting therefore did not, by itself, defer tax on the interest represented by those shares.
The Bench also held that Section 47(x) addresses whether the conversion is a transfer for capital gains purposes. It does not exempt the interest component embedded in the transaction, which the court said retained its character as taxable interest income under Section 56. The court further observed that the taxpayer could not claim TDS credit on the interest while denying taxability of the underlying income in the same assessment year.
The taxpayer argued that taxing the interest on conversion could result in double taxation when the shares were eventually sold. Addressing that concern, the High Court said that interest brought to tax upon conversion forms part of the cost basis of the shares acquired, avoiding double taxation on a subsequent sale.
The Bench concluded that the Assessing Officer had failed to conduct a proper inquiry and apply the relevant provisions. It upheld the Commissioner’s exercise of revisionary power, affirmed the Tribunal’s order and dismissed the tax appeal, holding that no substantial question of law arose. No costs were awarded.
The High Court said the taxpayer may raise her issues there, and directed that they be considered in light of the Tribunal’s subsequent rectification of an observation in its earlier order.
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